What Congress can do to lower the cost of inflation

Inflation is the highest it’s been in 40 years. There are many culprits — COVID-19, a 40 percent increase in the money supply, largely to finance COVID spending, the war in Ukraine, China supply-side disruptions and supply bottlenecks due to inappropriate shipping and trucking regulation.

Congress can’t change these factors. But it can help us all weather inflation, be it short- or long-term. Here’s how.

Fully index the federal income tax to inflation. Federal income tax brackets are already indexed, keeping workers out of higher brackets simply because their wages keep up with prices. But significant parts of the tax code aren’t. Take capital gains. When inflation pushes up the price of stocks, bonds, real estate and other property, people get taxed on the “gains,” even though they’ve experienced no increase in real income. The same is true for coupon clippers. Yields on standard (nominal) Treasury bonds, corporate bonds, savings accounts, etc. rise with inflation to compensate lenders for getting repaid in watered-down dollars. But the extra yield – due solely to inflation – is subject to taxation. 

At least index the taxation of Social Security benefits. Seniors are particularly vulnerable to inflation. Many live largely on fixed incomes. Others are, as indicated, getting taxed on illusionary capital gains or interest income. And the vast majority are at risk from inflation-induced higher Social Security benefit taxation.

In 1983, Congress started taxing Social Security benefits to improve the system’s long-term financial health. Above a certain level of income, seniors get taxed on an extra 50 cents of benefits every time they earn an additional dollar of income. That means, when they earn one more $1, they get taxed on $1.50. Thus, when seniors sell a stock, receive interest or dividend income, or withdraw funds from an IRA, their tax rate can be 50 percent higher than young people with the same income. At a somewhat higher level of income, the Internal Revenue Service (IRS) begins taxing 85 percent of benefits. At that point, seniors are facing a marginal tax rate that is 85 percent higher than young people with the same income.

Only a small percentage of the elderly were originally affected by this tax. But the politicians left unindexed the income thresholds beyond which the first 50 percent and then 85 percent of our Social Security benefits become taxable. This left inflation free, with no act of Congress, to raise more and more retirees’ nominal incomes above the thresholds, making more and more of their benefits subject to income taxation. 

Today, 56 percent of Social Security recipients are taxed on their benefits. Each percentage point of inflation raises this share. Without indexing the thresholds, all beneficiaries, rich, middle-class and poor alike, will eventually face income taxation on 85 percent of their benefits.

Tax only the real return on inflation-indexed Treasuries. Under current law, people of all ages can buy TIPS (Treasury Inflation Protected Securities) bonds — financial assets that protect them from inflation. Unfortunately, these securities do not shield investors from the tax law. To repeat, in periods of high inflation, the investors get higher returns but are forced to pay taxes on this phantom “income.” That means investing in TIPS is a terrible tax move if inflation continues to run high — since every penny of inflation protection income will be taxed. This helps explain why TIPS real yields (the yield apart from any inflation protection) have risen, rather than fallen, as inflation has picked up — to compensate TIPS purchasers for facing a higher effective tax on the security’s real yield. 

Have the Treasury issue I-bonds that function as inflation-indexed annuities. Cohort-Survivor I-Bonds would pay an inflation-indexed real return set by the Treasury. The amount that could be purchased annually would be up to, say, $25K per person. The return, which one would start receiving at 65, would be higher than on standard I-Bonds because you’d only get paid if you’re alive. The return set on newly issued Cohort-Survivor I-Bonds would depend on your birth cohort’s survival probabilities. Cohort-Survivor I-Bonds would establish a critically important missing financial market — one providing inflation-indexed annuities.

Eliminate Social Security’s earnings test. Over one-in-three 54-65 year-olds don’t participate in the labor market. For those 62 to 67 (the ages when you can collect early retirement benefits) the fraction working is just 40 percent. When COVID hit, many older folks joined the “Great Retirement” and took Social Security early. Now, if they return to work and earn more than $19,660, they’ll lose 50 cents in benefits for every dollar they earn. (The tax is 33 percent above $51,960 in the calendar year they attain full retirement age.) When this “earnings test” is combined with the Social Security benefits tax and regular income and payroll taxes, senior workers can face astronomically high marginal tax rates — even exceeding 90 percent.

Ironically, Social Security eventually reimburses most seniors for the loss of benefits due to the earnings test via its arcane Adjustment of the Reduction Factor (ARF) provision. The reimbursement comes in the form of a permanently higher benefit level starting at full retirement age. In other words, the government taxes you today and then gradually returns the money after you hit full retirement age.

The earnings test is surely leading millions of early retirees to permanently retire because they think they are being taxed to death because they have no clue about the ARF adjustment. Eliminating the earnings test would clearly make the government money. The elderly’s increased earnings would be subject to both federal income and FICA taxation. 

Eliminate Social Security’s (FICA) payroll tax for everyone over the full retirement age. Why is the government collecting a 12.4 percent payroll tax from people who, in general, have little to gain in higher benefits from paying more Social Security FICA taxes? This reform would likely more than pay for itself in the form of higher federal income taxes.

These reforms are important even with moderate inflation. With today’s very high inflation, they can be a life saver for many.

John Goodman is president and CEO of The Goodman Institute. Laurence Kotlikoff is a Boston University economist, president of MaxiFi.com and author of “Money Magic.”